Economics

Monetary policy

Something new?

I WANT to add a few thoughts to my colleague's assessment of the probability of new Fed action at the conclusion of this week's FOMC meeting. As he says, Ben Bernanke has never hesitated to intervene when deflation seems to be a threat, but when inflation is close to target it has not been willing to take unconventional steps simply to provide more support to labour markets. Mr Bernanke's Jackson Hole speech raised and more or less dismissed a number of the risks attributed to unconventional monetary policy actions. But he did nothing to signal a change in his thinking on the risks of above-target inflation: that expectations might become unanchored, destroying the hard-won monetary policy victory of the early 1980s and requiring a cycle of tightening and economic pain to set things right.

Regular readers will be familiar with my view on this: that it is mostly nonsense. Paul Volcker's victory was a difficult and painful one to achieve because it was unclear at the time that the Fed could bring inflation down. That is no longer the case. Episodes of above-target inflation since that time, in America and other rich countries, have not translated into soaring expectations. Most importantly, the commitment to the inflation target has kept demand growth constrained, preventing a return to potential output. The Fed's inflexibility on this point—its unwillingness to tolerate even a year or two of moderately higher inflation, despite the zero interest-rate-bound—has been the primary constraint on the pace of recovery.

And so, in the face of optimism that the Fed will act tomorrow, it's worth considering the chart my colleague presents, of 5-year inflation expectations as signaled by the 5-year breakeven rate. Expectations are back to the pre-recession level with which the Fed seemed comfortable. The Fed has never chosen to announce a new unconventional policy with expectations this high.

That should lead us to approach tomorrow cautiously. Now, it is possible that the Fed will announce new action and couple that with new guidance concerning its tolerance for inflation. That would be a powerful move that could lead to a change in the trajectory of recovery. It unfortunately seems the least probable outcome. A second possibility is that the Fed will recognise that some of the recent increase in expectations is a result of markets pricing in new Fed action, that it must therefore follow through to keep expectations at the current level, but it will also include tempering language designed to discourage the view that it is now open to temporary moderate inflation. In that case, expectations will likely plateau in the very near future, and growth should accelerate through the end of the year but not enough to change the overall recovery trajectory. That would be an outcome similar to that in late 2010, when expectations rose from August hints of forthcoming QE2, then leveled off on the actual policy announcement in November, before sinking again when further headwinds knocked the economy back off course.

And then there is a third possibility: that the Fed will attribute much of the rise in expectations to the erosion of downside risk in Europe and will conclude that new easing may leave inflation expectations dangerously high. In that case, no new action may be announced, markets might well backtrack, and the frustratingly sluggish growth of the past six months is likely to continue.

If I had to bet, I suppose I'd choose the middle option. I sure would love to see the Fed opt for the first option, if only for its experimental value. But there was really very little in Mr Bernanke's August speech to indicate that such a strategy change is in the works.

Consumer behavior is governed by expected lifetime income. At the moment, most Americans probably expect their income to grow by 0% per year. The assessment is probably wrong, but people will believe what they choose to believe. People also tend to pay especial attention to the prices of food and gasoline--that which economists ignore due to volatility. If you ask a man on the street, he'll probably tell you that inflation is around 5%.

The combination of these two uninformed conclusion yields a vague expected income growth of around -5%. That, of course, does not make people feel well-disposed. If the Fed launches another round of QE, I anticipate very serious public backlash.

I never mentioned anything particularly - that was another poster. I did say that econ theory concerning inflation refers to EVERYTHING available for trade.

With a fixed supply of money, a price increase in food or energy or gold or anything at all must be compensated by a corresponding decrease somewhere else - the math can't work and the market can't clear unless that happens. 'Course, that's a wickedly unpleasant turn of events - means other items have to be sold for a loss, and of course, wages are one item that can always fall.

The entire philosophy of contemporary economic thought is premised IMO on the (false) idea that prices can rise in one area without the necessity of prices falling elsewhere. It is said the perfect monetary policy can make this happen. IMO - that's a lie.

So when a drought hits and food prices increase, you believe the Fed should tighten the money supply? When natural gas production expands and prices go down, they should expand the money supply? How does that make sense? CPI doesn't include everything, sure, but the things it excludes are hugely volatile. We'd be radically changing policy every few months if we focused on food and energy. All those things you mentioned are still measured, so that "dishonest" tag is just trolling, but the point is that they aren't especially useful indicators. The cost of college are their own problem; it's not a monetary phenomenon. Medical expenses are actually included.

Michael Biggs and Thomas Mayer in their seminal analysis had brought out in their article, 'How Central Banks contributed to the Financial Crisis' (http://www.voxeu.org/article/how-central-banks-contributed-financial-crisis) that the excess credit growth stemming from the central bank action must match the change in spending. This credit pulse when looked at from the debt to GDP trend proves that such dosage of credit over time is a recipe for ballooning debt obligations that is hardly sustainable.

We are also forgetting that the Fed has the dual mandate of price stability (here exclusively Taylor’s rule is applied) and full employment (which is more indirectly ordained through credit growth and spending). But for both to act concurrently so that we have an adjustment process that could match the expectations of the market and also allow all the participants to make choices that do not act at cross purpose is something which we have seen time and again to falter. Every announcement has been preceded for example with a rising positive expectation that gets priced in the stock rally and then as we get to the day of the actual action we find a rather dampened rally. I would not be surprised if that is repeated this time. After all there is only very little that monetary policy could directly achieve on the second mandate, at least, while on the first it has been consistently raising some of the asset classes from the vagaries of stagnating prices, but only to be confronted by other bouts of 'not-so-good' leading indicators.

The Fed, as Woodward has pointed out, is still working on the basis of the lagging indicators.

R.A.'s back - and so too is the all too predictable siren song of 'inflation will cure all of our ills'. Something to be said for being a predictable Johnny-one-note - after all, original thinking is so insufferably ... 'elitist'.

Non CPI service price inflation is completely out of control. Medical inflation, education, etc... This is part of the reason state and local budgets are also out of control, student debt is to the moon, and many can't afford their meds. No amount of hedonic adjustments of Ipads will compensate for a doubling of food prices.

Monitoring only the CPI, which consists substantially of imaginary rent that homeowners don't pay to themselves), gives an inaccurate impression of what is going on in the real economy.

Right--if the central objective is to restore demand ASAP then its success will inevitably run into self-defeating supply constraints. My point was that buttressing demand is, for the time being, secondary to an orderly unwinding of the excessive and unsupportable credit that was created in the last run-up. First fill in the abyss, then build the mountain, so to speak.

The Fed might be more fearful of the downside of another credit meltdown than they are eager to restore capacity utilization. Another analogy that's rattling in my mind is that TEPPCO probably (rightfully) worries a lot less about electricity shortages than they do about an even worse case scenario at Fukushima Daiichi. Both are serious problems, but only one is existential.

Well that conclusion is backed by noting that Fed action has been very successful at turning around deflationary trends, but the recovery then slows when the Fed pulls back to prevent supra-2% inflation.

The regulatory uncertainty claim has been around for a few years with no evidence backing it, not to mention any evidence that regulatory uncertainty has increased since the recession.

"The Fed's inflexibility on this point—its unwillingness to tolerate even a year or two of moderately higher inflation, despite the zero interest-rate-bound—has been the primary constraint on the pace of recovery"

How would one come to that conclusion? The Fed funds rate as been declining or at Zero for over 4 years. The Fed cannot (or at leas has not) gone below Zero yet. I would postulate that the primary constraint on the pase of the recovery is not the Fed or its policies - but Government and Government Regulations - no one knows who or what business sector will be under government scrutiny or will be awarded government favor.

Perhaps we give Bernanke too little credit; it's hard to say from the summary statements. One possibility that hasn't been explicitly mentioned is that the Fed witnessed the run-up in commodity prices during the last up-cycle, believes that's what triggered widespread default and the disorderly collapse of credit, and perceives there to be a new speed limit on capacity utilization if you will. It's the rapid march to $150 oil that they're fearful of inciting, because perhaps it would be far more damaging to demand and anchored expectations than underwhelming stimulus measures. Perhaps some variant of peak oil-ism has crept in, and it's a delicate path to travel--slowly inflating away debts without too quickly/abruptly running into the energy supply restraints on the growth that such debts were predicated upon?